GUIDANCE IS DEAD, long live guidance. That was the message from the Bank of England this month with the publication of its latest Inflation Report.
Six months ago, the Bank’s new governor, Mark Carney, introduced a 7% unemployment rate threshold above which the Bank would not even consider raising rates. With unemployment converging on that level quicker than imagined, the Bank was under pressure to come up with a new strategy. Rather than a conditional pre-commitment, it has returned to a traditional style of policymaking – evaluating all of the economic news as it comes in to make a judgement on what it means for spare capacity and hence inflation. This is “guidance” in the true sense of the word.
Current policy settings – both interest rates and the size of the Bank’s balance sheet – remain a long way away from what we thought normal before the crisis. With the economy expanding at a brisk pace, albeit from depressed levels of output, it was important for the Monetary Policy Committee (MPC) to provide some direction to the markets. That direction came in three forms.
First, that spare capacity could be eroded further before rates need to be lifted – in other words, the Bank is happy to let the recovery run for some length of time before pulling the trigger on policy; second, that when the Bank does eventually take back current extreme policy settings, it will be done only gradually; and third, that the final resting place of interest rates will be far lower than what it was pre-crisis (in the decade to 2007, Bank Rate averaged around 5%).
Did the Bank give any clues about how long it might take before we see the first rate rise? The fixed income markets seemed to think so, moving aggressively to price in an earlier move than had been expected, given that the Bank has let its commitment expire. However, it is possible to use the Inflation Report to argue that the Bank may wait until later. After all, the Bank said it would like to see spare capacity completely eroded by the end of the forecast horizon, yet this would not quite be the case using the market profile for rates in the run-up to the February policy meeting.
Of course the Bank could be wrong on its judgement about spare capacity. The Bank told us that not only was spare capacity quite modest (1-1.5% of GDP) but that even strong economic growth of 3% annuailsed over the forecast horizon would be insufficient to eliminate it three years hence. That suggests the Bank is very optimistic about the supply potential of the economy. If this turns out to be too optimistic a view – reflected in continued weak productivity outturns – then spare capacity may be eroded more quickly which consequently could raise inflation.
That said, there are plenty of reasons to think inflation will fall further over the coming months – to rates lower than the Bank thinks, in our view. Weak rates of factory gate inflation, unit labour costs rising at less than their normal rate thanks to weak wages, sterling’s 10% rise over the past year, the existence of some degree of slack, global disinflationary trends and the British Retail Consortium telling us that shop prices are falling at their fastest rate on record are all reasons to expect disinflation – but not deflation.
On top of that, the Bank of England believes we have seen the peak in the rate of economic growth. In short, policymakers are unlikely to be feeling much pressure to raise interest rates in the short term. Concerns about financial stability – particularly in respect to the housing market – cannot be ignored and there is something to be said for the argument that loose monetary policy globally might be sowing the seeds of the next crisis through asset price bubbles. While both government and financial policy can attempt to address this before using the blunt tool of interest rates, it is important for central banks to explain clearly to borrowers that the era of exceptionally low interest rates will have to end.
George Buckley is Deutsche Bank’s chief UK economist